A. O. Smith Q4 2021 Earnings Call Transcript

Quartr
Provided by Quartr
January 27, 2022

There are 15 speakers on the call.

Operator

Good day and thank you for standing by. Welcome to the A. O. Smith Corporation 4th Quarter 2021 Earnings Call. At this time, all participants are in a listen only mode.

Operator

After the speakers' presentation, there will be a question and answer Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Patricia Ackerman. Please go ahead.

Speaker 1

Thank you, Shannon. Good morning, and welcome to the A. O. Smith 4th quarter and full year 2021 conference call. I'm Pat Ackerman, Senior Vice President, Investor Relations and Corporate Responsibility and Sustainability.

Speaker 1

Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer Chuck Lauber, Chief Financial Officer and Helen Gerholdt, Vice President, Financial Planning and Analysis. A friendly reminder that some of our comments and answers during this conference Call will be forward looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we have described in this morning's press release among others. Also as a courtesy to others in the question queue, We will be using slides as we move through today's call. You can access them on our website at investor.

Speaker 1

Aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to Slide 4.

Speaker 2

Thank you, Pat, and good morning, everyone. Thank you for joining us today. I'm on Slide 4 in our full year results. Our team delivered record setting sales and EPS performance despite a turbulent macro environment. Demand for our products in North America was strong An unprecedented inflation related pricing actions drove sales 19% higher over 2020.

Speaker 2

The Rest of the World segment performed well in 2021. China improved its operating margins to over 9%. We successfully navigated supply chain and transportation challenges and improved our delivery performance since the Q1. We acquired Giant, a water heater manufacturer in Canada, expanding our market share in North America and welcoming a talented group of employees to the AOS Smith family. With our dividend and share repurchases, we returned $537,000,000 of capital to our shareholders.

Speaker 2

Please turn to Slide 5. Our global AOS Smith team delivered record 2021 EPS of $3.02 A 42% increase that was driven in part by a record 22% increase in sales compared with 2020. Demand for our products was robust across geographies. We Achieved a strong performance as a result of continued outstanding operational and sales execution from our team. Despite the challenging environment of component shortages, logistical bottlenecks, immaterial and transportation cost inflation.

Speaker 3

I want to take

Speaker 2

the opportunity to thank my fellow AO Smith employees for their ongoing dedication and creativity. As we work to overcome these challenges to meet strong market demand and deliver for our valued customers. North America water heater sales grew 21% in 2021 due to pricing actions implemented in response to rising material and logistic costs and strong demand for our products. Commercial unit industry demand increased approximately 11% due to the resumption of new construction and replacements in the hospitality market segment. Residential unit industry demand increased by approximately 8% in 2021 due to strength in new construction and strong replacement demand.

Speaker 2

Our North America boiler sales grew 13%, driven by new construction and replacement demand, as well as the launch of new products. We ended 2021 with a record backlog, largely composed of commercial condensing boilers and January continues to generate strong order rates for these market leading energy efficient boilers, providing confidence in our outlook for the coming year. Our strategy to focus on innovation and decarbonization contribute to strong demand for our high efficiency condensing boilers. North America water treatment sales grew 14% in 2021 As we continue to pursue additional market share in this attractive fragmented market with a total adjustable market value that we estimate to be 2.6 Our strategy to pursue this market with an omnichannel approach has worked to grow our share through innovation, Product development and acquisition opportunities. We believe our independent water quality dealers have been outperforming the market and gaining market share.

Speaker 2

In China, full year sales increased 24% local currency compared to 2020, which was significantly impacted by the pandemic. Each of our major product categories grew year over year, including electric, gas tank, water heaters and residential and commercial water treatment products, along with replacement filters. Our water treatment business comprised of residential, commercial and filter replacement consumables now represents approximately 30% of our overall business with repeatable consumable filter sales representing over 20% of overall water treatment sales. I'm now on Slide 6. We know the efficient operation of water heaters and boilers can make a significant impact on mitigating climate change, and we are committing to doing our part.

Speaker 2

Reduction in energy use and greenhouse gas emissions are often top priorities for both consumers and contractors. As a result, adoption of sustainable building guidelines such as LEED and well building certifications continue to increase. I'd like to highlight some of our products that contribute to sustainable building practices and decarbonization efforts. Heat pump technology is a key consideration for many customers looking for a smart solution in both commercial and residential projects. We believe we are one of the technology and market share heat pump water heater leaders in North America and are well positioned to help our customers reduce their carbon footprints through innovative products.

Speaker 2

Adopting commercial and residential Energy Star certified products can contribute to lowering Greenhouse gas emissions and reducing negative environmental impact. AOS Smith is proud to manufacture more than 1,000 models of ENERGY STAR certified products, many of which are eligible for incentives via national eco rebates programs. The launch of our newest Crest commercial boiler with Hellcat Combustion Smart Technology is a significant achievement for us as it enhances the energy efficiency of our existing highly efficient Crest Boilers with Hellcat Technology reduced startup, maintenance and operating costs for our customers. I'll now turn the call over to Chuck, who will provide more details on the full year and Q4 performance.

Speaker 3

Thank you, Kevin, and good morning, everyone. I'm on Slide 7. Full year sales in North America segment rose to 2,500,000,000 19% increase compared with 2020. Pricing actions, largely on water heaters, represented approximately 70% of the increase. Higher volumes of water heaters and boilers were driven by strong replacement and new construction demand and higher volumes of water treatment products added to segment sales growth.

Speaker 3

Giant acquired on October 19, 2021 added $23,000,000 to North America sales. North America segment earnings of $591,000,000 increased 17% compared with 2020. The earnings benefit of inflation related Price increases and higher volumes was somewhat offset by higher material and freight costs. Segment operating margin of 23.4% was a modest decline compared with the 2020 segment margin despite significant cost headwinds. Moving on to Slide 8.

Speaker 3

Rest of the World segment sales of $1,000,000,000 increased 30% year over year with approximately 60% of that increase attributed to higher volumes. Our sales increase was positively impacted by lower channel inventory reductions in 2021 as compared to 2020. Channel inventory levels at the end 2021 were at the lowest level in 5 years. Currency translation of China sales favorably impacted Sales by approximately $58,000,000 Growth in each of our major product categories in China contributed to local currency growth of 24 New product introductions in the premium segment of the market, particularly our Slimline electric wall hung water heaters and water treatment products that deliver hot and ambient filtered water contributed to sales gains. India sales grew 31% in 2021 compared to 2020.

Speaker 3

We remain committed to India as a long term growth given its attractive growth characteristics and changes in demographics. Rest of the World segment earnings of $91,000,000 increased significantly over breakeven results in 2020, which were adversely impacted by the pandemic. In China, the benefits from higher volumes and favorable mix were partially offset by employee incentives and higher advertising as well as the absence of social insurance waivers that were received in 2020. Segment operating margin improved to 8.8% compared to 2020, primarily as a result of improved operating leverage from higher volumes. Please turn to Slide 9.

Speaker 3

Turning to the quarter 4th quarter performance, we delivered record sales of $996,000,000 in the Q4 of 2021, up 19% year over year driven by inflation related pricing actions, primarily in North America. Earnings in the 4th quarter were $0.87 per share, which is an 18% increase compared with earnings of $0.74 per share in the Q4 of 2020. Please turn to Slide 10. 4th quarter sales in North America segment rose to $715,000,000 a 27% increase compared against the strong comp in the Q4 of 2020. Pricing actions largely on water heaters and sales from Giant represented almost all of the increase.

Speaker 3

While volumes were strong relative to Our 20 2Q4 was exceptionally strong, creating a difficult comp. North America segment earnings of $167,000,000 increased 21% compared with 2020. The earnings benefit of inflation related price increases was somewhat offset by higher material and freight costs and lower volumes. Pricing actions trailed rapidly rising steel costs, which resulted in a lower segment operating margin of 23.3 percent compared with the 2020 segment margin of 24.6%. Moving to Slide 11, 4th quarter Rest of the World segment sales of $288,000,000 increased 3% year over year, primarily driven by favorable mix in China As consumers purchased our new higher priced products with more features and benefits, which was offset by lower China volumes compared to the Q4 of 2020, which benefited from pent up demand in China's economy emerging from the pandemic.

Speaker 3

Currency translation of China sales favorably impacted sales by approximately $9,000,000 Rest of the World segment earnings of $31,000,000 were in line with Q4 2020 segment earnings. In China, favorable mix offset lower volumes. Segment operating margin was 10.6% compared with 11.2 in the Q4 of 2020, primarily due to lower volumes. Please turn to Slide 12. We generated strong free cash flow of $566,000,000 during 2021, higher than 2020 due to higher earnings that were Our cash balances totaled $631,000,000 at the end of December and our net cash position was $435,000,000 Our leverage ratio was 9.7% as measured by total debt to total capital.

Speaker 3

Our strong free cash flow and solid balance sheet enables us to focus on capital allocation priorities and return cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.28 per share, which represents our 82nd Consecutive year of dividend payments. We repurchased approximately 5,100,000 shares of common stock in 2021 for a total of $367,000,000 Let's now turn to Slide 13. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation and new product development across all of our product lines and geographies. We continue to target strategic acquisitions with a focus on water heating and water treating assets that meet our financial metrics of accretive to earnings in the 1st year and return our cost of capital in 3 years.

Speaker 3

Please turn to Slide 14 and our 2020 earnings guidance and outlook. Adjusted EPS is introduced as a result of our termination of our defined benefit pension plan. The termination follows a strategy and measure glide path to derisk our fully funded exposure to pension liabilities. The plan, which was previously sunset for benefits earned on December 31, 2014, represents over 95% of the company's pension liability. The terminated plan's pension liability is expected to be annuitized in 2022.

Speaker 3

The pension plan settlement, which we expect will occur during the Q4, We'll accelerate the recognition of a projected $445,000,000 of non cash pretax Pension expenses or an EPS impact of $1.73 In addition, in order to protect our pension plans funded During 2021, we transitioned our pension plan assets to lower risk investments. The impact of this Transition will result in a lower rate of return on pension investments and accordingly higher pension expenses in 2020 compared to previous years. In order to provide transparency to the operating results of our business, in 2022, We will provide non GAAP measures, adjusted net earnings, adjusted earnings per share and adjusted segment earnings that exclude the impact of non cash pension income and expenses. Reconciliations from GAAP measures to non GAAP measures range of $1.56 per share and our adjusted EPS range of $3.35 and $3.55 per share. The midpoint of our adjusted EPS range represents an increase of 17% compared with 2021.

Speaker 3

Our outlook is based on a number of key assumptions, including That the Omicron COVID-nineteen variant, which is currently surging and impacting our production due to labor constraints, we currently have approximately 7% of our North America workforce out due to COVID-nineteen surge. Our outlook assumes that the variance subsides in the Q1 and we returned to the productivity levels that we operated at during the majority of 2021. Steel indices began to stabilize at the end of 2021 and we started to see the full benefit of our 5 announced 2021 price increases, which had a cumulative effect on water heating prices of approximately 50%. Our guidance assumes that steel prices in 2022 On an annual basis, we'll approximate steel market pricing at the end of 2021. We continue to see increases in non steel materials and transportation costs.

Speaker 3

Multiple 2021 price increases compounding to approximately 50% for water heaters as we exit 2021. We assume that approximately 45% of the cumulative announced price increase was realized in 2021 and the remainder will be realized in 2022. Previously announced mid to high single digit inflation related price increases in the remainder of our global portfolio. Continued strength in demand and backlog in North America for all of our water heating product While supply chain challenges have moderated As we move into 2022, we remain in close contact with our suppliers and logistic providers to troubleshoot, manage and resolve bottlenecks. As the environment remains unpredictable, particularly with the current surge and the omicron variant of COVID-nineteen.

Speaker 3

The integration of Giant, which we acquired in the Q4 of 2021 is on track and customer and employee feedback is positive. We project the acquisition to achieve annual synergies of approximately $5,000,000 over a 2 year period. Giant added $0.01 to EPS in 2021, net of customer repurchase accounting adjustments and one time transaction expenses. We reaffirm from our Q3 call that the acquisition is projected to add between $0.06 and 0 point 0 $8 to EPS in 2022. As for other housekeeping assumptions, we expect to generate strong free cash flow of between $500,000,000 $525,000,000 For the year, CapEx is projected to be between $75,000,000 $80,000,000 Corporate and other expenses are expected to be approximately $55,000,000 Our effective tax rate is estimated to be between 23 point 5% to 24%.

Speaker 3

And we expect to repurchase approximately $400,000,000 of Shares of our stock, resulting in outstanding diluted shares of 157,000,000 at the end of 2022. Based on these assumptions, the midpoint of our adjusted EPS range represents an increase of 17% compared to 2021. I'll now turn the call back over to Kevin, who will provide a little bit more color on our key markets and top line growth assumption outlook and segment expectations for 2022, while staying on Slide 14. Kevin?

Speaker 2

Thanks, Chuck. As Chuck noted, our outlook assumes the current surge of the Omicron variant subsides during the Q1. It does not significantly impact productivity or significantly impact the end markets that we serve. With the assumption as a backdrop to 2022, we project revenue growth for 2022 of 16% to 18%, which includes the following assumptions. After approximately 8% growth in each of the last 2 years, which is well above historical average growth rate.

Speaker 2

We estimate U. S. Residential water industry unit volumes will be down approximately 2% from last year as industry demand normalizes. We believe that commercial water heating industry volumes to be flat to slightly down as new construction and replacement installations Our China business performance was strong and stable in 2021. We expect China sales to grow approximately 5% in local currency in 2022, driven by demand of our residential and commercial water treatment products, including our replacement filters as well as range hoods and cook costs.

Speaker 2

We expect that sales of our residential water heaters in China will be flat to slightly down compared to 2021. We expect our North America boiler sales will increase approximately 10% in 2022. Our expectations are based on several growth drivers. And industry growth of 3% to 4%. We believe replacement demand is 85%.

Speaker 2

The transition to higher energy efficient boilers will continue, As commercial buildings improve their overall carbon footprint. In 2021, condensing boilers were approximately 30% to 35% of the commercial boiler industry that represents our addressable market. We believe the potential for the condensing boiler market is to represent 60% to 65% of the total market over time, which provides continued opportunity for our leading market share commercial condensing boilers and new product launches including a full year of our improved flagship crest commercial condensing boiler with Hellcat Technology and the introduction of a 1,000,000 BTU light duty condensing commercial Knight FTXL. We project 13% to 14% growth in sales for North America water treatment. We believe the megatrends of healthy and safe drinking water well as reduction of single use plastic bottles will continue to drive consumer demand for our point of use and point of entry water treatment systems.

Speaker 2

We expect margins to improve by approximately 100 basis points in 2022 compared to last year. Based on these factors, along with the full impact of our 2021 price increases, we expect our North America segment margin to be between 22.25% and 22.75% excluding pension expenses and rest of the world segment margins to be approximately 10% or 100 basis points higher than 2021. Slide 15, please. As we begin 2022, I'm focusing on key strategic priorities to advance our position as a leader in heating and treating water around the world. 1st, innovate and expand our DCAR portfolio, including heat pumps for space and water heating Expand our global water treatment capabilities by investing in technologies, people and distribution, deploy capital effectively by investing in ourselves, acquisitions and returning capital to shareholders.

Speaker 2

Thanks to the tremendous effort by our procurement and operation teams and their commitment to operational excellence, which is part of our DNA, as nearly 150 year old technology leader and innovative manufacturer, Our supply chain is stabilizing and our manufacturing lead times remain consistent. Through our focus and determination to serve our customers, We closed out the year on a high note and remained strong entering 2022. Our strong brands across the portfolio combined with harnessing of technology to drive innovation and new product development will enhance our market leadership. We are confident in our ability to capitalize on opportunities as we And finally, I have a bittersweet announcement. Pat Ackerman shared her plans to retire from her position as Senior Vice President, Investor Relations, Treasurer and Corporate Responsibility and Sustainability effective March 31, 2022.

Speaker 2

In addition to her many responsibilities, Pat has been a key contact for new and existing investors since 2008, coordinating communication and effectively delivering our message to our investor base. We thank Pat for her dedication to AO Smith, her leadership and her steadfast commitment to the values and principles of our organization. Pat's many contributions and impact will be long lasting. Please join me and Chuck and the rest of the A. O.

Speaker 2

Smith family And wishing Pat the very best in her well earned retirement.

Speaker 1

Thank you, Kevin, for your kind words. I am fortunate to have spent my entire 39 year career at a terrific company in AOS Smith and working alongside great people like many of you on this call today. I'm enthusiastic about And one of the key reasons why is my Investor Relations successor, Helen Goerkels. With over 2 decades increasing finance experience at AOS Smith, Helen most recently was Vice President and Controller and led our SEC reporting. You will find Helen to be knowledgeable and personable, and I know you will enjoy working with Helen as much as I have.

Speaker 1

With that, we conclude our prepared remarks and we are now available for your questions.

Operator

Please stand by while we compile the Q and A roster. Our first question comes from Matt Summerville with D. A. Davidson. Your line is open.

Speaker 4

Thanks and congrats Pat.

Speaker 1

Yes.

Speaker 4

Couple of questions. How should we be thinking about North America in Particular kind of the quarterly revenue and earnings cadence given what's a pretty significant number of moving pieces, how you have incremental price rolling Drew, how you're thinking about volume across the different product lines? How should we be thinking about that for 2022?

Speaker 3

Matt, this is Chuck. Good morning. So as we kind of look at 2022, overall, the cadence, when we look at 1st quarter, it's going to probably be the most challenging from a margin and perhaps the volume quarter. As you know, China is always weakest in the Q1 with the festival Gains momentum for the 2nd and third quarter and then the 4th quarter is the strongest. You should think of it very similar that way.

Speaker 3

Less moving parts in China perhaps because the Price and cost have not been that much of a move. Back to your North America focus, North America, A little lighter on the volume in Q1. There are some disruptions. Omicron has, as I mentioned, a bit of our labor force out. And we're going to if you look at steel, steel costs mentioned that we're going to still see In the Q1, we're going to have our highest steel cost that we've experienced as steel has been rising.

Speaker 3

We, as you know, Have a lag when we see the steel. So our Q3 to Q4 steel cost is going to be rising maybe 15% to 20% compared to Q4. So Q1 will certainly be challenged on the margin in North America a bit, though we do have our price increase offsetting that. So we have pricing coming in, A little bit higher steel. And so Q1 is our most challenged on the margin side.

Speaker 3

2 through 3 as you roll out the rest of and 4 as you roll out the rest of the year in North America, we do expect steel to moderate just a bit. You've seen the index come down, and so we expect margins to be a little bit stronger on the back three quarters in North America, With the price increase in full for all really all of the year. So that's basically the roll forward, kind of how to look at 20 2 from North America perspective. And we've got pricing I mentioned is about 45%, we believe on the water heating side, Effective that we've already seen. And so we've got 55% of that rolling in for 2022.

Speaker 3

Hope that provides a little better color on how it rolls out.

Speaker 4

Yes, it does. And just as a follow-up, you'd mentioned that inventory levels in China Stand at the lowest level you've seen in 5 years. I guess, do you feel or do you expect to see inventory start to bleed higher? Or is AOS Smith's objective going forward to really drive that number as low as possible so as to not have a repeat of some of the Some of the challenges you had in recent

Speaker 3

years. Yes. Our goal is to always keep it at the leanest level that's appropriate to serve our customers in China. Yes, it's at a low watermark. We wouldn't expect it to go lower than that at the end of 2021.

Speaker 3

So as we've said before, we keep a close watch on It's at a level where we feel is about as low as it's going to go to make sure we're serving our customers.

Operator

Thank you. Our next question comes from Scott Graham with Loop Capital Markets.

Speaker 1

Your line

Operator

is open.

Speaker 5

Yes. Hi. Good morning, Anna. Hardly congratulations to you, Pat. You've been Phenomenal and your job.

Speaker 1

Thanks, Scott.

Speaker 6

I have a couple

Speaker 5

of questions for you all. I guess the first one It is on the North American business. It looked like the 1st 2 months of industry shipments and resiwar heaters were up and your chart shows up volumes down in North America for the quarter. Could you maybe Give us a little more color on that.

Speaker 2

Hi, this is Kevin, Scott. As we discussed on our Q3 call, We had a challenging Q1 and we had been making progress through Q2 and Q3 and we Fully expected that to carry over into Q4. It lagged a little bit. And so that's what you're seeing. That is not indicative of order rates, that's not indicative of customers, but it did like a little bit.

Speaker 2

We expect to pick that up as We get into 2022. And I guess the comment I would make is our customer bases are solid. We've had no issues, no losses. And I believe based on customer feedback, we've really serviced our customers well throughout this pandemic and made sure they had the right And what we did at the end of this year as the our supply chain started to stabilize and so forth, We had some allocations out there for most of the year and we took those allocations off in December. So that's going to help drive maybe some additional orders as we get into Q1.

Speaker 2

But bottom line, I think we're in good shape. And As the industry normalizes and gets out of this turbulent sector, I think everything will move back to a much more of a normal Cadence and enormous share output for us.

Speaker 5

Okay. Thank you for that, Kevin. The Two other questions really. I know you have to start the year carefully with some of your estimates, and certainly that seems to have read through to a couple of the line items. I guess I'm thinking that when you say commercial flat to slightly down, I guess I'm kind of wondering where you're coming from on that one because we're still kind of I guess Omicron not

Speaker 2

a key part of that, but

Speaker 5

It just it feels like we're going to have a full year of reopenings, possibly even incremental reopenings versus 21, just sort of wondering why you would think that that would be a flat market for you?

Speaker 2

Well, I'll touch on that and then maybe have Chuck Jump in as well. When you look at we have a lot of reopenings in 2021. We had a very strong market. And as we go forward, it's a forecast. We believe that things will be a bit more normalized, Probably some of the proactive replacements won't be there.

Speaker 2

And so as we look out, very strong 2021, we think that's just going to peel back in 2022. But again, flat coming up, a very strong year, Scott, is pretty positive.

Operator

Thank you. Our next question comes from Susan Maklari with Goldman Sachs. Your line is open.

Speaker 7

Thank you. Good morning, everyone. And Pat, I'd like to add my congratulations as well to you.

Speaker 3

Thanks, Sue. Good morning.

Speaker 7

Good morning. My first question is, you mentioned that you have taken a lot of your Off of allocation in North America in December, can you just give us some color on where you think channel inventory set and How do you expect that your order rates could trend as those allocations have been removed?

Speaker 2

Let me touch on that one as well. 1, we're very specific on our order our inventories in China because we have really terrific visibility there. North America, it's more of a we don't have the same visibility, but based on the input that we have from our customers and so forth The inventories are basically in line. There's probably some gaps here and there. For the most part, I think the allocation Just freeze up maybe some orders.

Speaker 2

I'm not going to put a number on it quite frankly. But I do think we have limited Some of our customers and trying to be predictable for them, giving the right products to them, making sure that their deliveries were on time. So again, I think it's a positive thing for organization as we enter into 2022, removing the allocation and kind of get Active business as normal. And so that's kind of where we're at. No specific number I think I would want to add to that.

Speaker 7

Got you. Okay, that's helpful. And then as we do think about steel perhaps moderating or sort of coming off of this peak as we move through the year. How should we expect price will sort of trend with that? Do you think that as the volumes come off on the residential side potentially, you'll have to give back any of this price or do you expect that it will be fairly sticky?

Speaker 3

Yes. We've never had these sort of price increases like we've seen in the last couple in this last year, of course. So it's a little bit difficult to predict. We can kind of look at historically what's happened. Historically, we've generally been able to hold Share and margin and we react to the cost changes as necessary.

Speaker 3

So, bit hard to see how it plays out. We've got non steel costs in logistics and freight that even as steel costs have come down since our last call, we've only seen pressure and increase On all other non steel costs, we really have seen those surge a bit in the last quarter. So those somewhat offset some of the relief perhaps that might be happening on a bit of moderation on the steel side.

Operator

Our next question comes from Damian Karas with UBS. Your line is open.

Speaker 6

Hey, good morning, everyone. Congrats on the year and Pat, best of luck in your retirement.

Speaker 1

Thanks, Damian.

Speaker 6

So I wanted to ask you about some of your comments on China. So you're Expecting 5% sales growth there, but you mentioned water heater volumes flat to slightly down. Could you just talk about a little bit about your key assumptions driving your forecast there?

Speaker 3

Sure, sure. Yes, water heater volumes in China have been flat to down. When we look at the full year demand, I'll just kind of talk about what the overall 2021 consumer demand as best we measure through our channel. It probably was up 1% to 2%, The demand itself, so underlying demand when we get to the 5% and kind of think of it as 1% to 2%. There's a bit of pricing in China and we haven't nearly seen the Pressures as we've seen in North America, but that's perhaps another percent.

Speaker 3

And then when we think about kind of the new products, we've got some new products we've introduced. We've got the products I mentioned earlier in the statement on electric that are doing well and the gas products that are doing well, Range hoods, cooktops, commercial water treatment and water treatment overall, we feel pretty positive about, which kind of fills that gap to get you to that 5%. Year over year currencies, we expect to be roughly flat equal year over year. So that's kind of the bridge to kind of get up to that 5%.

Speaker 6

Okay, great. That's helpful. And then on water heaters, specifically in China, maybe you could just help us understand a little Kind of where mix is today compared to the pre-twenty 19 peak levels, if you will, obviously, Kind of you mixed down after that, but maybe any color around kind of the mid to premium price mix today relative to the past would be helpful. Thanks.

Speaker 3

Yes. So we're not at the peak where we were a mix in the peak Years before 2019, premium segment of the market was higher percentage of the segment of the market as we measure it at that time, But we are coming out of the trough. So we've got a year over year improvement in mix planned in 2022. Q4 was positive on mix. And the introduction of a couple of the new products we've just put out there help our mix because they're in the premium segment.

Speaker 3

So we're not at the peak. We're certainly not at the trough. We feel really good about the momentum coming out of it and positive about the new products coming into the market.

Speaker 2

Yes, I would just add, I mean, it's new products across our electric line, our gas tankless line, our water treatment that has Substantially well, it continues to grow. And so and then the kind of what I would call the newer segments, our commercial water treatment continues To do well and close over the $40 plus 1,000,000 And then Chuck mentioned range hoods and cooktops, which are gaining momentum. Overall, there's still going to be a COVID issue that we'll have to work through there and some spotty shutdowns that happened. And That may deal with a setback. There's still some de risking, but you put it all together, we came out of 4th quarter pretty well.

Speaker 2

We have some really good products on the premium side that are just getting into the markets fully. So we feel Real good about the mix and where it's going and hope to get back to those 2019 levels soon.

Operator

Thank you. Our next question comes from Nathan Jones with Stifel. Your line is open.

Speaker 3

Good morning, everyone.

Speaker 8

I'll add My congratulations to Pat and welcome to this part of the team, to Alan. I did want to follow-up on steel prices. I know you guys are talking about steel industry flattening out, but I think you have more exposure to coil steel prices, which have actually come down pretty substantially. Is that a potential significant tailwind from margins as we get into maybe the second half of the year once you've run through the higher cost Steel and inventory. And how is that balancing off against the inflation that you're continuing to see in other inputs?

Speaker 3

Yes, I mean our input on steel is about 70% cold rolled, 30% hot rolled. So those are the industries we're really tracking and There we've seen some moderation. We haven't seen it come down a great deal, but we've seen some moderation. Year over year, our steel is going to be up 50% in 2022 on average compared to 2021. So we still have that steel pressure there.

Speaker 3

Right now, I mean, it's early in the year, right? So we're looking at the increase of non steel costs components, the Logistics, we really haven't seen any relief on that. If we just kind of look through the rest of the year, our best Projection would be, if there is some moderation in steel on the index, we have seen a bit that the offset is largely in the non steel components. And We're not in our outlook calling for any we're calling for in our outlook when we look at it that Q1 is probably the most challenge and then it really the margins Sort of flatten out after that after we get over that kind of 1 quarter where steel is the highest.

Speaker 8

Thanks. I guess my follow-up then Around the margin guidance for North America, which is down a little bit from 2021. I think given you were chasing Costs up last year. You had some disruption in your manufacturing processes early in the year last year. I might have expected a little margin expansion in 2022.

Speaker 8

Can you maybe just discuss the puts and takes that are going into seeing margins a little bit lower in North America in Thanks.

Speaker 3

Sure, sure. So they are lower in our guidance than what let me just do a little reconciliation because If you exclude and I mentioned the non cash pension adjustment, that's about $10,000,000 that you'll see in our GAAP to non GAAP That will affect the margins a bit. And if you look at the Giant acquisition, which is performing great as we expected, performing well, but it doesn't have Quite the same margin as the rest of the North America business. Reconciling for those 2 really get us back to adjusted margins that are flat Compared to 2021, so 2022 North America is roughly flat compared to 2021. And That's with continued growth in North America Water Treatment and some of those other businesses that we're looking to expand our margin year over year.

Speaker 3

So the kind of expectation it may have gone up, we're really looking at flat and some of those other non steel costs that we're seeing are really filling that gap.

Operator

Thank you. Our next question comes from Mike Halloran with Baird. Your line is open.

Speaker 9

Hey, good morning, everyone, and congrats, Pat. It's been an enjoyable, What decade plus, I guess, but I've really enjoyed the relationship. So thank you.

Speaker 2

Thanks, Mike.

Speaker 9

So Maybe a similar line of question on China. Chuck, maybe just could you give the bridge on the China margins? And obviously, 10% is a nice increase here, but What are the puts and takes going from this year's to next year's margin level?

Speaker 3

Yes, I can do that. I mean, it's really It's up about 100 basis points. So we're kind of we're looking to expand from 9% to 10%, mostly on volume, Mostly on volume and mix. We got the products that we mentioned earlier and that they came into play in volume and mix. So we overcame a bit in 2021 to 2020, I mentioned the social insurance, that's about $12,000,000 for the year.

Speaker 3

So we like the progress that we made in 2021 to get us to 9, And then it's really volume and mix and leverage on the top line that gives us the 10.

Speaker 9

That makes sense. And then shifting gears to North America, when you think about the tankless heat pump dynamic in the water heater side, the residential water heater Any movement as you think about it through this year and how you're thinking about through last year, excuse me, how you're thinking about it this year? Any real change in the momentum that you've been seeing in any of those business lines relative to each other?

Speaker 2

I would say on the residential side, probably not any tank momentum. I think heat pumps have been growing year over year, becoming more popular. Obviously, there's more incentives out there and that's moving in the right direction. So we're in good position there. And I would say maybe on the commercial We're starting to see a bit more commercial heat pump up there.

Speaker 2

But let's step back, we still have a great Decarving footprint called condensing water heaters and condensing boilers. And that's also Trending well because there's so many applications that you really need the output and the heat of a gas fired product And being able to provide condensing boilers and condensing commercial water heaters also provides opportunity. So Commercial, I think you're going to continue to see just high efficiency growing and on both gas and on the kind of the heat pump side.

Operator

Thank you. Our next question comes from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Speaker 10

Hey, good morning, everyone. Best of luck, Pat.

Speaker 1

Thanks, Jeff.

Speaker 10

Just first on supply Shane, you mentioned a couple of times stabilization, moderation in the headwinds. Can you just speak specifically to what you see as getting better here near term?

Speaker 3

Just overall,

Speaker 2

you can't make any of our products without every component. And so it's and I say that when I'm smiling here, but overall as you start to become a bit more predictable, as our suppliers become a bit more predictable. And so that's what's been and then just some of the volumes coming up. We came out of a big freeze that impacted foam and oil based products. And Steel was running behind, but we're starting to see all these key components moving in the right direction.

Speaker 2

And so that's the stabilization. We're still very tactical tracking orders and making sure we're looking for alternatives, but we've been doing that for a year and it's worked out pretty well for our team. So overall, that's what stabilization looks like. That's why we were able to remove the allocation from our supply chain. And then I'm going

Speaker 3

to tell you we're going

Speaker 2

to have pockets of disruption occasionally here and there. We'll have to keep working through that. But That's where it's at. It's getting incrementally better. It's getting incrementally more predictable.

Speaker 2

Our suppliers just like us are stepping up They're gaining in production and deliveries, but it's incremental and we feel as we enter 2022, we're in better shape in 2021, Albeit, we have to see how the omicron surge impacts that. But as of right now, that hasn't been a large issue for us.

Speaker 10

Okay. And then just back on this kind of steel and pricing dynamic, it seems like cold rolled, which I think is your biggest input, is down 15% off of year end pricing. And just if that sticks, when do you start to see, one, the benefit of that? And Just remind us how the material price formulas work with the DIY customers where some of that pricing when that Some of that pricing might roll off. Thanks.

Speaker 3

Yes. So the decrease we've seen so far You know that it still has come down. We probably we will not see that until we get it probably into the middle of the second quarter. So there that's from a cost perspective. And then who knows where it will go from there, right?

Speaker 3

So it's gone down a bit. I'm not Sure. Our assumption is that it kind of stays at that level for the rest of the year. We've got we have certain customers that have pricing formula It represents maybe 25% of our water heater volume. And so the cadence on that follows similarly To kind of when you see steel indexes move.

Operator

Thank you. Our next question comes from David Gregor with Longbow Research, your line is open.

Speaker 11

Yes. Good morning, everyone. And Pat, thanks for all the help along the way. It's been great working with you and wish you all the best

Speaker 1

Thanks, Dave.

Speaker 9

I guess I just wanted

Speaker 11

to build on a couple of other questions that have been asked at this point. And maybe for starters, go back to the Discussion around China and mix and you talked about the fact you were seeing a stronger mix with the premium product. Clearly, that's a reflection of new product that introduced that, but are you seeing a similar trend across the broader market? In other words, is the Chinese consumer mixing up again? Or is this really AOS specific?

Speaker 2

Yes. Based on the data that we've seen and again, I'm going to relate it to more of the appliance side of the business. We see almost every Category on a year on year basis mixing up. So that's a positive trend that says a lot maybe consumer confidence and so forth In China, but yes, we are seeing it. It's not just in our categories, but others that we don't participate in.

Speaker 3

Yes, it's not back to the peak, but it's Couple of quarters now where I think we can start calling it a trend because we've seen an uptick.

Speaker 11

Yes, that's encouraging. And just on China, can you update us in terms of how you're approaching distribution and the growth of distribution in terms of 2022? What should we expect there in terms of new doors?

Speaker 3

Yes. So we really are focusing on 2 pieces really when you think about kind of the Tier 1 and Tier 2 cities, we are we're really looking at store efficiencies there. So we're continuing to be focused on store efficiencies. We're probably going to take out a bit more stores in 2022. We're at that pace.

Speaker 3

We've been on that pace For a number of years now, we're probably even out in the 200 to 300 store Taking out in 2022 compared to where we're ending the year in 2021, just not quite 6,000 outlets. On the other side, we're really looking to grow geography on the Tier 3 to Tier 6 cities. So think of that as low cost counters, we're just we're not having a promoter. It's very opportunistic. And those footprints, That's growing in the neighborhood of maybe 500, but don't do the math equal to the Tier 1 and Tier 2, but it's certainly opportunistic and it's Where we're really looking to continue to expand.

Operator

Thank you. Our next question comes from Andy Kaplowitz with Citigroup. Your line is open.

Speaker 12

Good morning, everyone. Best of luck, Pat.

Speaker 1

Thanks, Andy.

Speaker 12

Can you talk a little bit more about the competitive environment You're seeing in North America, you obviously have a very strong positioning in the core water heater market here, but you've also been aggressively raising price and you do have some competition Ramping up their own capacity now. So how sticky can your pricing be as inflation starts to normalize a bit and should we be at all worried about competitors ramping up their own capacity?

Speaker 2

Well, I worry every day. So, and I'm not being flippant. I mean, if you look at our business, we've been competing

Speaker 3

For 70 years in this industry, we continue to

Speaker 2

get up every day and focus on AOS Smith and AOS Smith's customers and our brands. And so there are clearly some kind of competitors coming into the market. We're going to continue to focus on what we do best And that's bringing innovative products to market, high service levels and making sure that we grow profitable with our customers. I'll go back to recent statements that we just really talked about is we've had no customer loss. I really believe That we've really taken care of our customers in a professional manager in a professional way and manage their expectations.

Speaker 2

And again, I always go back to this industry isn't about residential, gas and electric, isn't about Standard commercial, it's about bringing a portfolio of products to our customers and Not only residential and commercial, but the high technology newer products like heat pumps and condensing products that we continue to bring to the market. Perfect example is Hellcat technology on our crest boiler. All those things matter and we package that up together. We believe when we compete in the market, we have a value proposition That meets our customers' expectations and helps them grow their business.

Speaker 3

And then the only additional comment I'll make to that is And we called it out on our slides is that our R and D spend is over $90,000,000 and that's on water heating, water treating and we're really focused And those markets and as Kevin said, being a leader in product technology.

Speaker 12

Thanks for that. And maybe for my follow-up, in North American boiler sales, you talked about them 10% in 'twenty two after a good year in 'twenty one. So maybe you can talk a little bit more about the sustainability of the growth trends that are helping you in that business. I think historically it's been more of a mid single digit grower. And do you think you'll see any direct impacts on the infrastructure bill?

Speaker 12

And if so, when could they begin to occur?

Speaker 2

Well, I can tell you what we've seen certain segments. We talked about the educational segment last quarter that's been Certainly been helping us and providing opportunity. We're seeing more government institutional segments start to grow. So we are seeing some of that maybe that stimulus or that we're talking about in the marketplace. That's what's led to our record backlog that we have today.

Speaker 2

And that's going to stay with us, I think at least through 2022. I mean that we're looking at a 10% growth rate. And so overall, there's some stimulus out there. There's also just some pent up demand that may go back to the pandemic that we're I fill in that gap as well. And again, the replacement market is 85%.

Speaker 2

So you're going to have That natural replacement market continues. So overall, the boiler market looks strong. Orders are still Good. Coating activity is still good. So overall entering 2022 in a really good position in the boiler segment.

Speaker 3

Yes. And the thing I'll add on to that is, I mean, that 10% growth, there was some pricing that we did do On the boiler side of the business also. So there's a bit of carryover pricing that helps us a little bit, but we still see growth in the boiler market.

Operator

Thank you. Our next question comes from Brian Blair with Oppenheimer. Your line is open.

Speaker 13

Good morning, everyone. Pat, thank you very much for your help over the years. It's been a pleasure working with you.

Speaker 1

Thanks, Brian. Good morning.

Speaker 13

I apologize if I missed this. Did you cite run rate North American water treatment margins or the expected Margins step up as that business continues to scale double digits in 2022?

Speaker 3

Yes, we haven't, I don't think, but margins are around 11%. They were approaching 11% So we're pleased with the progress that we made, leverage and volume, the acquisitions that we need to continue to move forward on that. We're expecting about 100 basis points expansion in 2022.

Speaker 13

Okay. Appreciate that. And Circling back to commercial boilers, any feedback you can offer on the reception acceptance of your Hellcat technology since that's been out there? And how that factors into the backlog build that you've had and how we should think about the I guess the cadence of first versus second half growth netting to that 10% range that you've guided, given your backlog position, bidding activity, etcetera.

Speaker 2

Well, the Hellcat technology has been accepted and received very well by our contract and mechanical base. And so but that was at the later part of the year. So we really look forward into 2022 of having a full year with this new technology. And just to go back to it, we stated in our remarks, but it's not only higher efficiency, For startup that could take 2 to 3 hours takes 20 minutes sometimes now. Maintenance, it helps us get through the maintenance.

Speaker 2

It adjusts, so you don't have to go out there and do manual adjustments and the overall cost. So we're excited about it. It's a first to market, First mover, it's truly technology, different than what's in the market today. You bolted on a terrific product like the Crest. And And we just see that continuing to grow and gain momentum, particularly in the specified side of the business.

Speaker 3

Yes, not specific to growth, but Cadence of the boiler business is typically Q3 and Q4 are the strongest quarters. So and we still expect that in 2022.

Operator

Thank you. Our next question comes from Larry DeMari with William Blair. Your line is open.

Speaker 14

Thanks. Good morning, everybody. And certainly, congratulations, best of luck to Pat.

Speaker 1

Thank you.

Speaker 14

Yes, we won't get this deal one last time for a field trip. So I was kind of curious, I know you touched on this, but as it relates to China with inventory to 5 year low, I believe you said, but only looking up 5% for the market. I mean, I know there's confidence stuff, but can you delineate between consumer demand and channel fill? And are we holding the channel back at all from refilling? It just seems like there might be some Schedule upside there?

Speaker 3

Good question. We don't believe we're holding the channel back. I mean, I will say we had strong order rate at the end of December that we certainly did get out in January, but we're not it may go up a bit. We don't expect it to go lower. So as we kind of think about 2022, channel inventories do get a bit lumpy, but they've been really honed down to a pretty lean level.

Speaker 3

And If anything, we expect it to slightly go up, but we're going to keep that in a close watch.

Speaker 14

Okay. Thank you. And then you guys also mentioned the impact of Omicron, I think in the Q4 into the Q1. If you could just kind of clarify that mostly North America is a little bit in China also and how meaningful is that impact?

Speaker 2

Yes, it's primarily it's almost exclusively North America, particularly with the number of people that we have out. So China, again, very little, but again, that's spotty, depends on the region. India is the same way, but really the Omicron surge has really impacted our North America businesses and we're working through it. It has But we hope that we'll start to see a beacon will come down and we'll get through it in the Q1 and kind of put this Phase of COVID in the rearview mirror.

Operator

Thank you. And I'm currently showing no further questions at this time. I'd like I'll turn the call back over to Helen Gerholt for closing remarks.

Speaker 1

Thank you for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered Strong sales and earnings despite many challenges in 2021. We are optimistic about our results in future periods based on a durable strategy, Robust demand for our products as well as strong execution of our strategy despite an environment challenged by component shortages, logistical bottlenecks, inflation in both materials and transportation costs and pandemic related surges.

Speaker 1

We look forward to updating you on our progress in the quarters In addition, please mark your calendars to join our presentations at 3 conferences next month: R. W. Baird on February 22nd Cindy on February 23 and Barclays on February 24. Thank you and have a great rest of your day.

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Earnings Conference Call
A. O. Smith Q4 2021
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